Corporate earnings and stock market outlook 2016

Nigeria’s business climate experienced fresh difficulties in 2015 arising from election-induced economic slowdown and the sustaining revenue constraints facing the public sector. A drop in economic activity undermined the production and consumption functions in the economy. The absence of adequate economic buffers could not permit stimulatory spending needed to keep the economy streaming on an even keel. Consequently, companies faced serious problems on both sides of producing and selling.

Consumer spending capacity weakened further in 2015, as unpaid salaries mounted, job losses persisted and domestic prices increased. These developments and their multiplier effects hurt sales revenues of companies across various sectors and industries.

The ability to consume what industries and businesses are managing to roll out has dropped and this has serious effects on corporate earnings performance. On the production side, the ability to produce has been undermined significantly by the restrictive measures the Central Bank has taken to defend external reserve. The depreciation of the naira has also altered the cost-income relationships of businesses generally to the detriment of the bottom line. The ability of companies to grow wealth for investors has been seriously constrained.

Most companies could not pass on increased costs to consumers and this affected profit margins. The ability of companies to grow profit consequently weakened in 2015. Companies having foreign currency denominated obligations are harder hit, as they have suddenly found their operations unsustainable. Companies heavily dependent on imported raw materials have run into losses due to sudden cost increases they cannot pass on to consumers.

With the depreciation of the naira and high interest rates, Nigeria had one of the most difficult corporate earnings environments in the world in 2015. While policymakers are looking at macroeconomic numbers, there is a grassroots deterioration of consumer spending capacity, which is the critical factor for corporate earnings growth.

In the environment of cash and credit squeeze, companies have built up monuments of supplier credit that is equally hurting their capacity to grow sales volume. On the other hand, they also need to apply increased consumer credit inducements to defend market share and improve sales revenue. The operating conditions have cast a general picture of poor corporate performance in terms of ability to grow turnover and shareholder value in 2015.

The underlying corporate purpose of growing wealth for shareholders came under further threat in 2015 and this cuts across sectors and industries. There was pressure on both sides of converting assets into revenue [asset turnover] and in converting revenue into profit (profit margin).

Revenue capacity is undermined by low consumer spending and profit capacity is undermined by cost increases. Finance charges led rising costs and banks too are feeling the pain by way of rising interest expenses and declining net interest income.

The hopes for any profit improvements in 2015 lie on industry leaders and major players with dominant product names. Companies with substantial dependence on local raw materials are equally promising on earnings prospects. Such companies may be found in the agricultural and building material sectors. The general cost-income trends last year are declining or flat sales revenue, rising operating cost and declining profit.

Companies will no doubt be affected at different degrees and some companies can be expected to move against the trend and such companies are the first choice destinations for investors at the moment. Watch out for companies able to grow sales revenue as per interim reports because they most likely gained market share at the expense of competitors. Equity investors will do well to look for industries and companies with good profit margins and those able to cut cost or prevent costs from growing along with sales revenue.

Companies that have huge balance sheet debts and those that have raised their debt profiles are bound to suffer loss of profit capacity due to high interest burden. Companies that deal on products with low price appeal may be able to improve earnings performance by capturing consumers resisting price increases elsewhere.

The difficult operating environment is the outcome of a major scale down of economic activities that preceded the general elections. This happened through a gradual process that began in 2014. While pre-election slowdown is a usual occurrence in Nigeria due to high prospects for electoral violence, the slowdown experienced in respect of 2015 election was more than usual due to heightened political uncertainty.

The operating environment in 2016 needs new growth stimulants for companies and industries. Decisive actions are critical needed in two fronts – dealing with the effect of the business slowdown and – activating the forces of a new growth and these have to happen as quickly as possible.

The operating space lacked sufficient growth stimulants for companies and industries in 2015. While leading companies might be able to maintain moderate growths in revenue and profit, a general slowdown in earnings can be expected in the 2015 reports. The explanation for this is the inability of consumer spending to match the cost increases. Labour unions would ordinarily have embarked upon demands for wage increases in 2015 except that even the current salaries were unpaid.

Purchasing power of consumers remains weak and only high priority consumer facing companies may be able to record moderate improvements in sales revenue in 2015. Only very few with superior selling strategies may be able to achieve accelerated growth in sales volume. Stimulatory spending by government is imperative to spur recovery in consumer spending and prevent the simmering cash and credit squeeze from getting to a flashpoint.

Most companies could not push sales volume in the difficult market in 2015. So, they focused on how to improve or defend profit from the slowly growing sales revenue by cutting back costs. It is more likely that the few companies that may be able to grow profit in 2015 will most likely do so by reducing cost and improving margin than by growing sales revenue. This rules out the many highly indebted companies that are presently carrying heavy burdens of high interest charges.

The operating climate remains essentially hostile to the host of small players and penny stocks that remain trodden down under intensifying competitive hostility. In 2014, companies recovering from prior year profit drops led the high profit growth company chart. In 2015, a few of the small operators managed to find some oasis of survival and recovery despite the competitive choke.

Corporate earnings weakness in 2015 will expectedly register adversely on the stock market performance in 2016. A good strategy in the circumstance is to move into equities with the best fundamentals. This is a kind of run into safety since such stocks are the best in defending investment values. And when confidence returns to the market, they are sure to lead share price advances.

The prevailing low confidence in the equities market is equally caused by the shaky position of foreign portfolio investors. Equities have been the leading source of foreign capital inflow for several years but a major slowdown happened in 2015. These high returns seeking traders are averse to the risk of exchange rate losses as well as foreign remittance restrictions. The risk and return relationship that propelled their coming into Nigeria has tilted to the side of risk.

Latest data available shows that investment in equities remains the leading source of foreign capital inflow but a massive drop in 2015 is quite worrisome. Some recovery and stability in investment inflow is needed this year for a better stock market performance in 2016.

Another issue of concern is that interest rates are still high enough to discourage equity investment despite the reduction in the monetary policy rate last November. Stock market performance is likely to be subdued as long as the Central Bank keeps short-term interest rates high. Companies cannot embark upon major earnings capacity building programmes as long as interest rates remain high. Weakening corporate earnings performance may therefore continue to linger on, which could reinforce the downside risk for equities.

Share prices reflect both current and future earnings capacity of companies and neither is looking impressive for this year. Traders and investors will be eager to see companies resume building of future earnings capacity in 2016, which will provide the basis for any reasonable share price recovery this year. The extent this could happen has a lot to do with government policy choices and actions that define the corporate earnings space.

A low interest rate policy, desirable as it may be, looks very much like a tall order, particularly as the naira exchange rate remains under pressure. The pressure to cut interest rates further is however expected to mount this year. A medium-term engagement of the stock market will therefore appear to be appropriate and the best move will be to look out for the most promising equities on fundamentals.

Greater professionalism can be expected in investing and trading activities, as market operators seek to convince themselves on why they should invest in a company. Having learnt the bitter lessons of investing without investigating, market operators can be expected to undertake intensive corporate performance probes this year. The ability to grow profit and pay reasonable dividends will be the key determinants of which company’s stock will move up in price.